In this article, I expand on last week’s article on how I choose stocks. I additionally offer insight on the importance of dividends and my thoughts on day trading.
- Invest in what you know.
- What index funds are and how efficient they are.
- My method for choosing stocks and explaining how dividends work.
- My thoughts on day trading.
Invest In What You Know
Newer investors might be enticed by what experts have to say about hot stock picks. However, you should consider investing in what you already know. Specifically in an industry that you are employed in.
Your ability to ascertain high quality companies versus low quality is to your advantage compared to your average investor. Your overall knowledge of the industry will be your best asset in this endeavor.
I also encourage you to use what knowledge you have about other industries. For example, everyone knows about Coke, Pepsi, Disney, and JP Morgan Chase, these are well-known companies. Reasons that are likely aligned with their business plans, providing excellent customer service and their ability to market their companies.
These are the types of companies you want to own if you are starting out. You want to develop a stable foundation with strong companies that are bound to last for many more years. Think of investing as a long term contribution to your retirement rather than making a quick buck.
Simplicity at its finest, index funds offer a wide range of stocks in one selection. The best part about index funds is that you are guaranteed returns for little to no work.
Index funds are mutual funds that offer a collection of companies at a decent price comparing to purchasing individual stocks. Since it offers such a large amount of companies for small percentages, you are diversifying effectively.
The diversity within each fund allows you to have the peace of mind that if one stock tanks, your portfolio’s value will not be affected drastically. Essentially reinforcing the idea of not putting all of your eggs in one basket.
Index funds are a great and safe pick for anyone that is not interested in learning about the ins and outs of investing.
What are the benefits of investing in an index fund?
- Large diversification within index funds.
- Guaranteed returns, typically outperforms professional hedge fund managers
- Provides dividends
- Cost efficient for investors
- Great for passive investors
What are the negatives to investing in an index fund?
- Lack of control
- Does not cover every industry with one index fund
Since you are investing in a large collection and owning small percentages of each company, your portfolio is dependent on how the market performs. Also you are unable to sell any stocks individually within that fund, as it would require you to sell the entire index fund. However, with this in mind I still believe index funds are one of the best methods of passive investing.
To give you an idea of how effective index funds are,
The chart above shows the steady and consistent growth of index funds, reflecting identically with how the market is performing.
A list of popular index funds:
- Vanguard Total Stock Market Index
- Vanguard High Dividend Yield ETF
- Fidelity Total Stock Market Index
I encourage you to research more about index funds at reputable brokerages such as Vanguard, Fidelity and Charles Schwab as they are the main ones that come to mind when I think of high quality brokerages. Granted, there are many more out there, but these three are the main services that I believe offer great options.
In the previous section I mentioned dividends being an essential contributor to compound interest. Dividends are payments that companies provide to shareholders on a set schedule every month, quarter, semi-annual, and annual payment. To reiterate, you are being paid for owning their shares.
The holy grail to my financial freedom! Dividends are my priority when it comes to deciding on what companies to invest in. Last week, I provided a snippet of my portfolio. As a student in college, I have limited funds after my fixed expenses. This in turn has geared me towards defensive investing, prioritizing long term growth, high dividend yields and “safe” companies.
As your original deposit will naturally grow by market gains and compound interest, dividends will accelerate the growth if reinvested.
We can see the importance of compound interest and dividends being reinvested. The difference between both charts is that reinvesting your dividends added an extra $6,351.82 to the portfolio’s value! You are effectively utilizing your money in a manner where it requires you to do absolutely nothing.
When I am deciding what company is a good fit for the portfolio, I look at their dividend history, dividend yield, dividend growth and overall safety.
Criteria list that I follow:
- Dividend growth, is it consistently growing?
- Dividend history, do they have a track record of at least 10 years?
- Safety score, provided by simplysafedividends or other accredited rating service.
Dividend history and growth can be checked on any financial website, I prefer to use SeekingAlpha. To demonstrate this, I will be using AFL as my example.
The chart above is AFL’s dividend growth history, this is one of my main points of concern when deciding if a company fulfills the criteria that I am looking for. As we can see, AFL’s history indicates a consistent trend of dividend growth. It also indicates a long track record that goes back to 1992, their first dividend payout.
Therefore, to me as an investor who is prioritizing dividends, it would be a no brainer to purchase AFL in times of uncertainty. AFL has shown us that it is capable of withstanding economic downturns and they pay their dividends during downturns as well.
AFL’s dividend safety rating is a 99, it’s the safest rating that simplysafedividends provides as there is always a chance that a company might cut or reduce their dividends. AFL’s current dividend yield is 3.14%, which is higher than its 5 year annual dividend yield.
To reiterate, my method of deciding what companies to raise my stakes in are based off of information on seekingalpha and simplysafedividends. Primarily revolving around information on dividend history, growth and safety ratings. Both websites offer high quality analyses and are great for beginner level investors to learn from.
Disclaimer: Simplysafedividends is a subscription service but they do have a 14-day trial, I highly recommend you check them out as their team is full of qualified CPA’s and analysts.
Why I Don’t Do Day Trading
Day Trading: Purchasing and holding stocks for a very short amount of time, generally a couple of hours to a day.
Simply putting it, I do not have the means to afford the losses incurred by day trading. There is too much risk involved, the rewards do not outweigh the losses to come.
To name a few issues I see with day trading,
- Short Term Gains Tax
- Ability to make consistent returns
- Must have capital to make considerable returns
Short term gains tax, this is the main reason I will not participate in day trading. Why would I put my hard earned money in a situation just to be taxed 10% to 37%? The immediate effect that you would experience after selling is the transaction fee and the gains tax depending on your tax bracket.
Since short term gains tax are taxed at the same rate as your ordinary income. The way that taxes work, it goes against day trading for people with little capital.
In a research report performed by a group of professors from UCB, UCD and Peking University, they found that only 13% of day traders make a net profit in any given year. To make it worse, only 1% of day traders are able to outperform the market with consistent returns.
The underlying issue with day trading revolves around taxes and commissions. Supporting my original claim that short term gains tax and transaction fees will diminish your returns significantly.
I would like to stress the importance of investing and speculating as well. Day trading is a speculative approach since you are expecting stocks to fluctuate in one direction in a given day. This is not investing but gambling would be a more fitting term.
This is not my attempt at discrediting people who day trade as a profession. However, a majority of new investors who take up day trading with little to no experience end up failing. The emotional aspect of investing is what brings many investors down, as inexperienced investors will get caught up in the rush of high returns and panic when a slight correction occurs.
The likelihood of anyone making considerable returns after taxes and transaction fees is unlikely. In the case that people do make returns they become disillusioned by their brief victories and exaggerate the outcome. Potentially creating a disastrous event after their beliefs have been misplaced in a system that is volatile and unsustainable.
Another reason why I believe day trading is not a good option is you must have a decent amount of capital to start with. Keeping in mind the fact of short term gains tax and transaction fees being prevalent, any considerable return must be above these limitations.
Overall, I find that day trading is something out of my reach and too risky as an endeavor for myself. It does not fit into my investing strategy and I do not encourage new investors to immediately take on day trading.
Thank you for taking the time to go through my article, I hope you found the information useful and informative. As always, feel free to contact me at firstname.lastname@example.org if you have any suggestions or questions. Stay healthy and until next Thursday.